by Shane Oliver (Chief Economist AMP)

Will Australian interest rates ever go up?

While the global economy is seeing its fastest growth in years and the US Federal Reserve has increased rates five times since December 2015 and is on track for more hikes this year, the Reserve Bank of Australia (RBA) has now left interest rates on hold for a record 21 months in a row. The Australian economy is in a very different position to the US. While the RBA continues to expect that the next move in rates is most likely to be up, and we tend to agree, we now don’t see a hike until sometime in 2020. And the next move being a cut cannot be ruled out. This note looks at the reasons and what it means for mortgage rates, the $A and investors.

Four reasons why rates will be on hold into 2020

We have been looking for a rate hike in early 2019, but have now pushed that out to 2020 for the following reasons:

First, growth is likely to remain below RBA expectations. A bunch of factors will help keep the economy growing: the drag on growth from falling mining investment is largely over; non-mining investment is rising; infrastructure investment is booming; and net exports should add to growth helped by strong global conditions. However, against this housing construction is slowing and consumer spending is constrained with downside risks around slow wages growth, high debt levels and falling house prices in Sydney and Melbourne. Personal tax cuts likely to be tabled in the Budget will help keep the consumer going but are unlikely to offset all the drags. So while growth will likely improve from the 2.4% pace seen last year, it is likely to be to between 2.5% and 3%, below RBA expectations for a pick up to 3.25%.

Second, wages growth and inflation are likely to remain low as growth is unlikely to be strong enough to eat into significant spare capacity in the Australian economy. Some say Australian rates just follow those in the US but there has been a big divergence in recent years. In 2009 while the Fed left rates near zero the RBA started raising rates only to start cutting them from 2011. And while the Fed started hiking rates in 2015 we continued cutting them in 2016.

Source: Bloomberg, AMP Capital

There is good reason for the RBA to lag the Fed. Labour market underutilisation (see next chart) at 8% in the US is about as low as it ever gets whereas in Australia its around 14%. If wages growth is only just starting to pick up in the US despite a much tighter labour market it’s no surprise that it will take much longer in Australia.

Source: Bloomberg, AMP Capital

Continuing weak wages growth along with excess capacity and high levels of competition in goods markets will keep underlying inflation around the low end of the RBA’s 2-3% target for a lengthy period yet.

Third, bank lending standards are going through yet another round of tightening as the household debt boom comes to an end, doing the RBA’s work for it. Now it relates to policies and practices around borrowers’ income, expenses and total debt levels. This has been driven by APRA which is shifting away from blunter constraints on lending to certain categories of borrowers (such as the 10% speed limit on credit growth to property investors) and is receiving added impetus now. This will particularly hit lower income borrowers and high home price to income markets like Sydney and Melbourne. Tougher checking of income and expenses and constraints in terms of the amount of loans going to high total debt to income borrowers will likely lead to a slowing in credit growth in the months ahead. While a credit crunch is unlikely its hard to reliably predict the impact of tighter lending standards.

Finally, house prices are slowing led by falling prices in Sydney and Melbournewith more weakness likely. APRA measures to constrain investor and interest only borrowers have worked. These measures, combined with poor affordability, rising unit supply, falling expectations for price growth and the end of FOMO (fear of missing out) are pushing prices down. The latest round of tighter lending standards will add to this, as will any move to lower immigration levels (and curtail negative gearing and the capital gains tax discount were there to be change in government).

Source: Domain, AMP Capital

Capital cities other than Sydney and Melbourne face a much better outlook as they did not see the same boom in recent years. However, we see prices in Sydney and Melbourne falling another 5% this year, another 5% next year and with further slight falls in 2020. We are running around levels for price growth and auction clearance rates that in the past have been associated with the start of interest rate cutting cycles (in September 2008 and November 2011 – see the previous chart), not rate hikes! The risks of a sharper fall in prices if investors lose faith, homeowners decide to reduce high debt levels and if the shift from interest only to principle and interest for many borrowers over the next few years creates problems needs to be allowed for. Raising rates when prices are falling will accentuate these risks.

As a result of these considerations, we have pushed our timing regarding the start of interest rate increases into 2020. Of course, the risk here is that by 2020 the US economy may be weakening making it hard for the RBA to then start considering rate hikes. And of course, if the declines in home prices turn out to be deeper the next move could end up being a cut.

Won’t mortgage rates rise anyway?

Since the time of the GFC “out of cycle” changes in bank mortgage rates have been common. However, the main driver of significant changes in mortgage rates remains what the RBA does with the cash rate – see the next chart. It cut from 2008 and mortgage rates fell. It hiked from October 2009 and mortgage rates rose. It cut from November 2011 and so mortgage rates fell. This makes sense as the banks get around 65% of their funding from bank deposits the main driver of which is the cash rate. However, the remaining 35% can cause some variation as will regulatory changes which saw higher rates for investors and interest only borrowers recently.

Source: RBA, AMP Capital

There are two main pressures at present. The first is a rise in money market funding costs in the US and Australia of around 0.3 to 0.4%. Given that only 10-15% of bank funding comes from this source its unlikely to have much impact. And the banks are unlikely to pass on the extra costs to owner occupiers on traditional loans given the Royal Commission, but banks could raise rates for investors and interest only borrowers. Higher US bond yields could also place some pressure on bank funding costs but again this is likely to be modest, and probably unlikely to result in higher rates for owner occupiers on traditional loans. The main thing for traditional borrowers to watch is the cash rate. If we are right, such borrowers will see pretty stable mortgage rates out to 2020.

What about the $A?

With the RBA likely on hold and the Fed set to keep hiking the interest rate gap between Australia and the US will go further into negative territory. Historically, this means a fall in the value of the Australian dollar. The $A appears to be starting to break below the rising trend channel that’s been in place since 2015 and we see more downside to around $US0.70. A fall to below $US0.50 as we saw in 2001 is unlikely as commodity prices are likely to remain much stronger than they were then.

Source: Bloomberg, AMP Capital

Implications for investors

First, bank deposits are likely to continue providing poor returns for investors for a while yet.

Second, as a result assets that are well diversified and provide decent income flow remain worthy of consideration. This includes unlisted commercial property and infrastructure along with Australian shares which continue to offer much higher income yields compared to bank deposits.

Third, Australian bonds are likely to outperform global bonds which are dominated by the US as US bond yields rise (on the back of Fed tightening) relative to Australian yields (which will be constrained by on hold RBA cash rates).

Finally, with the $A likely to fall further there is reason to keep a decent exposure to global assets on an unhedged basis.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

By Geoff Wood (Morphic Asset Management)

OVERESTIMATING RISKS

Humans tend to fear spectacular, but unlikely events. This is the proposition that Bruce Schneir makes in his book “Beyond Fear”.For example, European tourism has been significantly impacted by much talked about terrorist attacks despite the extremely low probabilities of something occurring to any individual. With the anniversary of October 1987 recently, it was remarked that “the week after the crash people started worrying about a crash”. The more recent an event’s occurrence is to you, the more likely you are to think that event is going to happen (when in fact it’s actually a lot less likely).

UNDERESTIMATING RISKS

What does this look like? Overall we tend to underestimate threats that creep up on us. Humans are ill-prepared to deal with risks that don’t produce immediate negative consequences, like eating a cupcake or smoking cigarettes. For example, surveys show more people fear dying from cancer than they fear heart disease.

As markets push on globally to new highs and talk of bubbles emerges, I thought it would be timely to take a look back at the last century to see what the world looked like when markets were making all-time highs before a big correction.

In the below table (Figure 1), we identify seven major highs in the US S&P 500 stock market. The criteria for identifying a “major high” was twofold:

the market was making highs; and

it was followed by a market fall of at least 25% in the following 18 months. Why 25%? Because falls of 15-20% are relatively common in a bull market. The ongoing bull market since 2009 has already had two of these episodes.

The first thing that should strike a reader is how rare these events are: seven times in 90 years so roughly every 12 years. So in one’s investing life (~40 years), there should be on average 3 “events”. For all the talk of fearing crashes every year, one should not bank on them too often – meaning the old saying “time in the market is more important than timing the market” has a ring of truth to it.

Importantly though, note that they are not evenly spread at 12-year intervals as we observe a clustering around the 1960s and the early 2000s. For whatever reason, these events have tended to “clump”.

FIGURE 1 – MARKET HIGHS USING OUR TWOFOLD CRITERIA

Source:Bloomberg, Team Analysis

DELVING INTO THE DATA

I then looked into a selection of market and macroeconomic data points to see what they were indicating at these market tops (Figure 2). Some statistics include:

and the Federal Reserve’s level of interest rate and perhaps more importantly how much had it changed coming into the high.

The first thing to note, which is to be expected, is there is not one consistent signal across all the outcomes. I say if there was consistency, markets would already be using the indicator! But a few pertinent points do jump out:

stock market highs before a crash have occurred two thirds of the time when unemployment was below 5%;

in most cases, the Fed has been hiking;

consumer expectations have been elevated but falling;

and PMI surveys of future expectations have been mixed.

However, the last two market highs were made with confidence starting to wane, while for prior occurrences it was strong and strengthening.

FIGURE 2 – ECONOMIC DATA AT THE HIGHS

Source: Bloomberg, Team Analysis

VALUATIONS AND MARKET DYNAMICS

S&P valuations have had a wide range from 10 to 25x price/earnings (P/E) over the last century, reflective of the wide range of deflation, inflation, reflation and stagflation that markets have lived through.

We find that market tops in the S&P have tended to occur when the market was expensive – but not eye wateringly so – at around 20x. The 2000 dot com top was an exception with the market trading closer to 30x.

In most cases, P/E’s are expanding into market tops, which is a sign of continued confidence about the future (Figure 3).

FIGURE 3 – VALUATIONS AT HIGHS

Source: Bloomberg, Team Analysis

WHAT DOES THE RUN-UP TO A PEAK LOOK LIKE?

Are stocks losing or gaining momentum into the peak?

Figure 4 looks at the path coming into the peak. Prices have generally risen 20% or more in the 18 months preceding the high and are 30% above any lows in that same period. The range can vary hugely with “blow-off” moves off 48% in 1987.

Breadth measures how many stocks in the S&P 500 are making 52-week highs. A strong market is driven by many areas. For the different dates studied here, there are mixed messages as the 1987 high was across the board, while the 2007 high was only driven by a small number of areas. It seems to us that the overriding factor/indicator is either low breadth or narrowing breadth.

The Relative Strength Index (RSI) in Figure 4 measures the consistency of buying and a figure over “70” is largely seen as overbought or overvalued. All market highs involved the monthly RSI being around or above the widely sighted 70 figures, signaling consistent strong buying over an extended period.

FIGURE 4 – MARKET DYNAMICS AT THE HIGHS

Source: Bloomberg, Team Analysis

HOW ABOUT OTHER ASSET CLASSES?

Lastly, I thought it would be instructive to look at how other asset classes were performing into the equity market top. If something is going wrong with liquidity or the economy, these assets should be reacting as well (Figure 5).

The bond market is generally seen as a better identifier of recession risks than stock markets and as such, it typically starts to price the central bank cutting rates in advance forcing the yield curve to flatten. The yield spread between the two-year and ten-year yields in a healthy market is typically around 100bps but going into the last two corrections was significantly lower.Credit markets are also worth watching as again there is a view that credit “fails” before equities. My examination shows this is indeed the case: in the last few cases, spreads have been widening while the market went into a top because of the credit market prices increasing default risks.

FIGURE 5 – OTHER ASSET CLASSES AT A STOCK MARKET PEAK

Source: Bloomberg, Team Analysis

SUMMARY

So back to the original question. What does underestimating risk look like?The highest risk points for investors, with the benefit of hindsight, was when there appeared little left to worry about. Unemployment was low; consumers were confident; and investors were willing buyers of equities month after month, driving big market moves upwards into the end. I would speculate that during these periods, the “fear” became more about “fear of missing the rally” rather than avoiding a crash.

On the flip side, when everyone is talking about risks such as Europe imploding or North Korea firing missiles, this may just be the time to buy.

One last thing to bring to the reader’s attention is the risk of “false positives”. We only know in hindsight what the tops were. The data can also be consistent with outcomes where a market top doesn’t take place. The most recent example of this was just last year: credit spreads widened, driven by falling oil prices; PMI surveys fell below 50 (indicating a contraction); and the market dropped more than 15% at one point. Yet the data reversed and the market rebounded to new highs. The market is not designed to be easy…

Taken all together, the analysis supports what we have written before: this bull market is moving to the late stages but these indicators I have analysed do not indicate a market top is imminent yet.

As the market continues its grind higher, we will be aiming to stay alert to market complacency and a change in these indicators.

Markets have moved to price in three hikes for the RBA’s cash rate by end 2019. Other major banks concur broadly with that view.

Recall that in mid-August last year, these same players (markets and most other banks) were forecasting rate cuts over the course of the remainder of 2016 and 2017. Westpac’s view at that time was “rates on hold” in 2016 and 2017.

Readers of the Westpac Market Outlook publication for September will be aware that Westpac continues to forecast the cash rate to remain on hold out to mid-2019.

Indeed we are not convinced that the cash rate will need to rise any time throughout the course of 2017, 2018 or 2019.

This approach is clearly different to the thinking of the Reserve Bank Governor himself who expects to be tightening over that period (note his speech on “the next chapter” which was delivered yesterday).

However, we continue to point out that the RBA has a very different growth outlook for the Australian economy and Australia’s trading partners to our own.

The RBA expects growth in Australia to be 3.25% in 2018 and 3.5% in 2019 (above trend of 2.75%). Westpac expects a below trend pace of 2.5% in both years.

The RBA is also forecasting 2% underlying inflation in 2017 and 2018 (bottom of target band) to be followed by 2.5% in 2019.Underlying inflation is currently running at 1.8% (to June) and the upcoming revised weights are likely to reduce annual underlying inflation by 0.2-0.3%.

Going forward, the RBA’s inflation forecasts also look to be overly optimistic and are likely to be subject to downward revision. Recall that in 2016 when the RBA was forced to revise its inflation forecasts below 2% it believed it had little choice but to cut rates.

While the RBA does not provide detailed forecasts outside growth and inflation, comments from the RBA Governor and written reports point to a much more confident outlook for wages growth; incomes; employment; consumption; non-mining investment and the residential construction cycle.

The Reserve Bank expects wages growth to increase over the forecast period. A major puzzle for central banks globally has been the limited response of wages to stimulatory monetary policies since the GFC. Despite these policies in the US; Germany; the UK and Japan driving labour markets to near or full employment, wages have failed to respond. Explanations for this phenomenon have been structural: globalisation; technology; retiring higher paid baby boomers; low productivity growth; absence of pricing power for employers; low inflationary and wage expectations; high risk aversion following the GFC and job insecurity.

Consistent with that global theme, wages growth in Australia has also been weak. Australia’s wage price index has increased by 1.9% over the last year compared to average growth of 3.5%. The unemployment rate has held in the 5.5%-6.0% range compared to a generally accepted full employment rate in Australia of 5%.

Further, underemployment in Australia has been high at around 8.8% making total excess capacity around 14.5%. Given the global lessons on the structural wages outlook, it seems unlikely that wages in Australia (where spare capacity is higher than in these other developed economies) will lift significantly even in the medium term.

This weak wages performance has lowered annual real income growth to 0.6% while real consumption growth has held around 2.5%. The shortfall has been funded by a falling savings rate, particularly in the highly stressed mining states. Overall Australia’s household savings rate has fallen from 9% to 4.6% over the last three years.

Households will need to protect that fragile savings rate and pressures will emerge on consumer spending. Of course, other pressures are impacting households – rising energy prices; record high debt levels and political uncertainty. The latter effect will work through the business sector as businesses restrain employment and investment until political clarity is achieved following the 2019 election.

Markets may be underestimating the impact on the interest rate sensitive housing market of developments which are unfolding without official rate hikes.

The four majors (90% of the mortgage market) have been raising investor and interest only mortgage rates while applying tighter lending guidelines. House price inflation is slowing and regulators are unlikely to have any patience with a reversal of this trend.

To that point, six month annualised house price inflation (CoreLogic data) in Sydney has slowed from 22.4% in January to 4.8% in August. We observed a similar response to macroprudential policies in 2015/16 when six month annualised house price inflation slowed from 25% (July 2015) to -4.4% (April 2016).

Housing activity is also slowing despite a steady cash rate. Other factors, specifically relating to foreign investors, have turned the cycle. High rise building approvals have tumbled by 40% in the last year. This has been particularly due to investment restrictions in China; lending constraints by banks; and sharp increases in state government stamp duties for foreign investors. This downturn is likely to continue for at least a further two years.

While markets are currently captivated by expectations of a coordinated lift in global growth, we are more circumspect particularly around Australia’s trading partners.

With Chairman Xi likely to cement power following the National Congress in October, we expect that he will have little choice but to adopt policies to gradually deal with the excessive build up in corporate debt in China (now 166% of GDP), largely driven by the circa 30% compound growth rate of small and medium sized banks and non-banks over the last six years. These small banks now represent comparable asset bases to the heavily regulated policy banks which have only been growing at around 12% over the same period. It will be incumbent on the administration to arrest the growth rate of these small banks; off balance sheet vehicles; and non-bank institutions. Asset quality for these institutions must be suffering while reliance on overnight funding has lifted sharply.

Tighter credit conditions will slow China’s growth rate – we forecast a growth slowdown from 6.7% in 2017 to 6.2% in 2018.

Finally, the ongoing legacy of elevated risk aversion, which continues ten years after the Global Financial Crisis, is contributing to unusually steady interest rates around the world. Under our figuring, on the basis that this risk aversion persists for a few more years, a 40 month stretch of steady rates in Australia would not be out of place.

The Reserve Bank Board next meets on March 1. We are confident that the Board will decide to keep rates on hold.

The Governor has made it clear that the Bank will be most closely monitoring progress in the labour market and whether there is any evidence of the recent turmoil in financial markets impacting domestic demand in Australia.

In that regard time will be required to get a clear read on those developments. Markets remain reasonably confident that the necessary information will be available by May with market pricing implying around a 60% probability of a rate cut by then.

We remain comfortable with our long held view that rates will remain on hold throughout 2016.

We were not particularly concerned about the lift in the unemployment rate from 5.8% to 6.0% given that the move was consistent with our forecast that unemployment would edge up to around 6%. That forecast has been contrary to the Bank’s forecast that the unemployment rate would continue to fall through 2016. However we do not expect that the RBA to be too perturbed by the result given the month to month volatility and that ‘trend’ unemployment rate estimates continue to track lower.

Evidence around the impact of the financial turmoil on domestic demand will not be clear for some time. Early evidence around consumer sentiment (up 3.5% in February) and business conditions (stable in February) is not pointing to significant signs of any fallout.

Of course the path of the Australia dollar will also be a key input to the board’s deliberations over the course of the next few months. In that regard the path of the US dollar and US monetary policy will be key factors.

Over the last week I have been travelling in the US meeting with policy officials; real money managers; hedge funds and economists.

Some key themes around US monetary policy; the US dollar; and the state of the US economy have become clear.

The starting point is current market pricing. With virtually no FED hikes priced in for the remainder of the year our current call for three hikes by year’s end looks decidedly ‘courageous’. However that needs to be put in the context of a category of views expecting the FED to be reversing its December rate hike and moving rates into negative. Those low end expectations are skewing market pricing and masking the forecasts of other participants who are expecting a series of FED moves over the course of 2016.

The areas of serious debate are around the US’s current potential growth rate. With very weak productivity growth; growth in the working age population having slowed; and the participation rate weak, even allowing for improving demographics, estimates of potential growth in the US are stuck in the 1.3–1.7% range.

General forecasts for growth in 2016 are around 2%, almost exclusively because of the boost in spending from consumers as strong employment growth boosts incomes and households decide to spend more of the windfall from falls in the oil price (current estimates are that only around 50% of windfall has been spent). Little hope is held out for postive growth contributions from government, inventory accumulation or investment while net exports can be expected to remain a drag.

However, if growth does exceed potential then further falls in the unemployment rate can be expected. Concerns around a sudden lift in wage pressures (which are already building) once the unemployment rate reaches, say, 4.5% are held in many quarters (the debate around the actual level of the NAIRU is lively). Lags between wages and inflation are estimated at around six months making the FED’s inflation target of 2% easily achievable and even posing a potential need to lift the Fed funds rate. This scenario is clearly the key risk to current market pricing.

Evidence is cited that in US states where the unemployment rate has fallen below 4.5% wages growth has reached 3–4%.

This indicates that the link between wages and the unemployment rate still holds although at levels of the unemployment rate that are well below what had previously been expected to be the trigger point. It was further speculated that the lift in wages growth might be non-linear.

On the other hand there is clearly discomfort with the elevated level of the USD (considered to be the most important source of tightening financial conditions). Official research points to the impact on the US economy of the US dollar having long lags (it is notable that since the Fed raised the federal funds rate in December the US dollar index has fallen somewhat). The impact on growth of the 25% lift in the USD over the last two years is still to fully work through the economy. Resumption of the FED’s tightening cycle by June might risk a further substantial lift in the USD, intensifying the drag on the economy.

Earlier periods of USD strength have been associated with much stronger growth particularly due to strong productivity so a 0.5% drag from exports is much more significant when potential growth is 1.3%–1.7% than when it is above 3%.

Resolution of this policy dilemma will play out over the next six months or so. It may take policy makers longer than June to assess the US dollar effect on the one hand and the risks to wage inflation on the other.

Our current view is that the authorities will tread a middle ground. Policy will need to be tightened in anticipation of potential wage pressures but will be focussed on avoiding a USD lift through 2016 of more than 8–10%. Clearly the key variables to watch are jobs growth; the unemployment rate; wage pressures and of course the path of the USD.

Shane Oliver has long thought of the US Federal Reserve’s quantitative easing program (QE) as a bit like a drip keeping a patient in a coma alive until it can be brought out of the coma and survive on its own. The patient was the US economy post the GFC and the Fed was administering the drip. Quantitative easing involved the Fed using printed money to pump cash into the struggling US economy by buying up government bonds and mortgage backed securities. The first two rounds of QE ended prematurely in 2010 and 2011 before the US economy was ready to be taken off life support. However, having learned its lesson the phasing down of the latest round – commonly called QE3 – was made contingent on the economy strengthening. The Fed has concluded that this has happened so has been “tapering” its bond purchases all year and is now bringing them to an end.

But has QE worked? Was it worth the costs? What next? What does it mean for investment markets?

Has QE worked?

Quantitative easing sounds extraordinary – and in the context of the inflation prone world we all became used to it would have been. But given the deflationary shock delivered to the global economy from the GFC it is not. QE was needed to boost the supply of money in the US economy given the difficulties in pushing interest rates negative.

Quantitative easing helps the economy via: lower borrowing costs; more cash in the economy; forcing investors to take on more risks; and by boosting wealth, to the extent it drives shares higher, which boosts spending.

But has it worked? While there is much debate, at the end of the day the proof is in the pudding. And the evidence clearly suggests it has worked. While the US economy is still far from booming: growth has picked up pace; bank lending is strengthening; housing construction is recovering; consumer spending growth is reasonable; business investment is strengthening; business conditions are strong; employment is above its early 2008 high and unemployment has fallen to 5.9% (see the next chart); and deflation has been avoided.

Source: Bloomberg, AMP Capital

By contrast, the European Central Bank has dragged the chain on QE and so the Eurozone has unemployment stuck at 11.5% and inflation at just 0.3% is flirting with deflation.

Could the Fed be too early again?

In 2010 and 2011 the Fed was too quick to end QE. There is a risk now too. The global economic expansion is still uneven and US inflation is below the Fed’s 2% target. However, most US growth indicators are now in far better shape, so the risk is reduced. For example, compared to 2010 & 2011 unemployment is lower, employment is higher (previous chart) and consumer confidence and durable goods orders (a guide to investment) are higher (see next chart).

Source: Bloomberg, AMP Capital

But what about the costs – was it worth it?

Most of the arguments against doing QE don’t hold water:

There has been no hyperinflation. US inflation is less than 2%. The mistake the hyperinflationists made was to confuse a surge in narrow money such as cash and bank reserves which rose with QE with a surge in broader money supply measures such as M2 and credit which hasn’t happened. And they ignored the spare capacity in US factories and in the labour market.

Financial market distortions are relatively modest. Yes bond yields are low but this mainly reflects the reality of a long period of sub-par growth, low inflation and excess savings rather than distortions caused by the Fed’s holding of US bonds. And the forward price to earnings multiple on US shares at around 15 times is actually below its long term average and less than suggested by current bond yields. That said, maintaining easy money longer than need be does risk creating bubbles, but I doubt we are there yet.

Currency wars. There was much concern in the emerging world that the $US would crash pushing emerging market currencies up or leading to uncontrollable capital inflows. In the event this was really much ado about nothing and more recently the argument has been run in reverse with some emerging market countries complaining the phasing down of US QE would cause capital outflows and a collapse in their currencies!

Inequality in the US had been worsening long before QE. While it may be claimed that QE by boosting share prices accentuated inequality because more rich people hold shares, the alternative of allowing the economy to spiral on down and unemployment to surge would hardly have been good for equality. Moreover, other factors including technological innovation are arguably more important in explaining rising inequality in the US.

The exit problem. This is the biggest risk. Given the lack of experience with quantitative easing there is a degree of unknown regarding the impact of exiting from it.

Much of the critique of the Fed has come from gold bugs and disciples of the Austrian school of economic thought that holds that periods of financial excess should be allowed to fully unwind to allow a proper cleansing of the system. As such they saw the Fed as interfering with the natural order of things and so foresaw dire consequences. The problem with this is that it ignores the role of free market forces in causing the problem in the first place and the likelihood that if free market forces are able to run their course numerous innocent bystanders would be adversely affected. This was what happened in the 1930s when US authorities stood by and allowed a 50% collapse in industrial production, the demise of hundreds of banks and 20% plus unemployment. Hardly a great outcome and hardly great for equality. So there is a case for monetary policy to smooth any adjustment in the economy, which of course is what QE has done. Knowing what the Fed knew about the risks around the GFC and the lessons of the 1930s they have done the right thing. To let the patient die (well not quite – but you know what I mean!) would have been morally indefensible.

What next?

If things go according to plan the next step is that the Fed will actually start to tighten. This will come in the form of raising interest rates and starting to reverse its QE program. It looks like it will primarily unwind its bond holdings by not replacing them as they mature, as opposed to actually selling them.

However, the Fed has made it clear that tightening is contingent on the economy continuing to improve and signs inflation is moving up to target. It has also continued to point out that it anticipates a “considerable time” to elapse before it starts to tighten. This reflects the fact that growth is still far from booming, labour force underutilisation remains, inflation on the Fed’s preferred measures is just 1.5% and inflation expectations have been falling. Our base case is the Fed will start raising rates and allowing maturing bonds to run down its bond holdings from around mid-2015. But if economic conditions are weaker than expected it could come later and a renewed round of quantitative easing cannot be ruled out.

What does the end of QE mean for shares?

Memories of the last two times when QE ended are fresh. After QE1 ended in March 2010 US, global and Australian shares fell around 15% and soon after QE2 ended in June 2011 shares fell around 20%. Fears of a re-run when QE3 ends have been one factor behind the recent roughly 10% correction in shares, so investors have partly pre-empted it.

Source: Bloomberg, AMP Capital

However, while the ending of QE3 may add to volatility it’s very different to the premature ending of QE1 and QE2, which occurred when the US was a lot weaker. Now the US economy is on a sounder footing. And while US QE has ended, it’s being replaced by QE in Japan and Europe.

It’s also worth noting that the rally in shares over the last five years is not just due to easy money. It has helped, but the rally has been underpinned by record profit levels in the US.

Source: Bloomberg, AMP Capital

Finally, it should be noted that US QE is ending because the economy is stronger, which is a positive for shares.

What about the impact on Australia?

The ending of US quantitative easing is a positive for Australia for two reasons. First, it’s another sign the US economy is on its feet again and a stronger US is good news for Australia as it means a stronger global economy. Second, it removes a source of upwards pressure on the $A, allowing it to continue its downtrend, once current oversold conditions are relieved, which will likely see it fall to around $US0.80 over the next year or so. This will help the Australian economy rebalance as the mining boom fades.

Concluding comments

With the US economy now on a sounder footing, the Fed is right to end its quantitative easing program. While this could contribute to short term volatility in shares, providing the US continues to grow as we think it will and given that we are a long way from tight monetary conditions the cyclical rally in shares that got underway back in 2011 is likely to continue.

Shane Oliver

Chief Economist - AMP

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The US Federal Reserve have announced that they will cease purchasing bonds and other securities as part of the Quant Easing program (affectionately known as money printing).

We discuss this with Dom Guiliano, portfolio manager at Magellan Financial Group and get his views as to what this might mean for interest rates both in the US and Australia in the medium term.

Below the video we have also provided a transcript of the video.

TRANSCRIPT

Mark: I'm here with Dom Guliano, portfolio manager at Magellan Financial Group. Thanks for joining us today Dom, and we're talking about America now. We've been around the round the world so far. And theoretically America's going to finish their money printing program later this year - or that's what's expected. Are you able to give us an update of where that, which is commonly as quant easing. Can you give us a fly over view of where that program's at and what some of your likely expectations are from here?

Dom: Right, so--

Mark: A tough question for you.

Dom: So, the Federal Reserve is being quite clear about it's intent to phase down the quantitative easing program over the next couple of months. So, we should probably see new purchasers of securities come down to zero, certainly by the end of the year.

Mark: So they'll stop buying?

Dom: They will simply stop buying. They will still have a very large balance sheet.

Mark: Yes.

Dom: Of purchases that they have made, and we're talking about 2.4 trillion, that kind of number. But they should be able to keep that balance sheet under control. The next step, the next step, really then becomes one normalisation of monetary policy. So, the Federal Reserve has been flagging in a number of different ways that short term interest rates might move up from zero to something, over the course of - or beginning sometime next year. And there's a lot of speculation - in the second quarter, third quarter, first quarter. Like, we don't know and really we don't care so long as that direction's a good one. We expect, given the positive fundamentals that we're seeing playing out in the US economy, the strength--

Mark: Like unemployment and economic growth.

Dom: Yeah, exactly. The economic growth continues to show positive indications. Unemployment continues to decrease, which improves household wealth. Propensity for households to buy is improving. The number of houses sold is increasing. House prices are increasing. Business investment is slowly increasing. So, all of the ingredients for a sustainable recovery and a strengthening recovery are there. So, whether it's one or the other, from our perspective, if it's long term investors doesn't matter too much. I think one area to be thinking about over the medium term is what normalisation might actually look like. Are interest rates going back to four and a half percent, four percent, five percent, three and a half percent? There's a bit of a question mark around that, given the nature of the recovery, given perhaps some structural issues. One of the areas that the Fed Reserve President Yellen has been talking a lot about is the quality of the unemployment rate. What she means by that is unemployment might be going down, but certainly the number of jobs that have been created - typically of weaker quality than we normally see in a recovery--

Mark: So more part time employment?

Dom: So, what kind of jobs - casuals - the average wage is less, indeed, wage growth over the last number of years has been weaker than you normally see coming out of recovery. So there's some underlying weakness that is being masked by the headline unemployment rate, which might colour the nature of monetary policy over the next couple of years.

Mark: What would be your gut feel on how you will see normal monetary policy coming out in America, as in whether you think rates are likely to normalise given where they have come from, where they are at the moment?

Dom: If you look at history, normal kind of suggests something between four and five percent is where interest rates should line up. But there's a lot of interesting stuff going on around the world, so how long it takes to get to get to normal is quite a different question. And when I say, "interesting stuff going on around the world," - you've got Abenomics (Japan) continuing and Japan has got it's own quantitative easing program, right? So, they're busy buying bonds in overseas markets, including US treasuries. We talked earlier about the weakness in the Euro zone, which is likely to provoke a quantitative easing program of some sort out of the Euro zone. And again, it's a weakness out of that market, money printing out of that market. You've got a slowing Chinese economy. Now, North America and the United States doesn't operate as an island, it deals with the rest of the world and there will be some feedback loops into how monetary policy and the nature of the recovery in the United States progresses as it will. So I think you need to keep that in mind.

Mark: Yeah, yeah. I think one of the other things, just to finish off on is - we're talking about America here, but everything impacts globally. People in Australia will think, "Well, that's got nothing to do with us. So, American interest rates are likely to have some impact on Australian interest rates I would have thought. What's your view on that?

Dom: Oh well, very much so, I suspect Glenn Stevens of the Reserve Bank hopes that there is a significant impact in rising interest rates. So, typically, if markets behave as they should behave, when the interest rates go up in a country that supports their currency relative to other currencies - so if interest rates go up in the United States, that should result in a strengthening of the US dollar, relative to other currencies, including the Australian dollar. Which means a weakening of the Australian dollar relative to the US. Similarly a weakening of the Euro relative to the US. Now that of course will be beneficial for our export sector and also should reduce imports, so you should see some import replacement and that should be beneficial to the Australian economy.

Mark: And given that Australia requires funding from overseas, if we're competing for capital with America, if they increase their rates, does that automatically mean that our rates have to go up to compete with that?

Dom: Look, the central banks do have a fair degree of control over the level of interest rates. That wouldn’t be my primary concern. Markets are fairly liquid. The primary borrowers actually are the Australian Banks, and they've got a very good degree of access offshore . The mechanism really won't play through in terms of increasing interest rates in the United States automatically meaning increasing interest rates in this country. But there are beneficial impacts all through the currency.

Mark: Well really good information and particularly relating back to how it affects us here in Australia. Dom, thank you for your insights, that's fantastic, and I wish you well for the rest of the year.

Dom: Thank you very much Mark.

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As widely expected, the Reserve Bank Board left the cash rate unchanged at 2.50% at its June policy meeting. The stance more generally was also unchanged with the key closing paragraphs of the Governor's accompanying statement identical to those following the May decision.

The body of the statement had some notable points of change however.

Commentary around the AUD was somewhat more pointed. Recall that the Bank's comments on the currency have seen a significant evolution over the last year with rhetoric becoming particularly forceful late last year, with the level regularly described as "uncomfortably high".

That rhetoric was toned down in Feb following the upside surprise on the Q4 CPI, with the Bank simply noting that the exchange rate remained high by historical standards. We speculated last month that the policy 'comfort' from the weak Q1 CPI might lead the Bank to resume its more pointed commentary on the currency but it chose instead to keep the statement wording unchanged. This month we get a little more elaboration with: "The exchange rate remains high by historical standards, particularly given the further decline in commodity prices". As the RBA has pointed out many times, it is the relativity between terms of trade and exchange rate moves that are key to growth prospects - the tweak suggests the mix of a still fairly stable currency at elevated levels and falling commodity prices is again causing some angst.

Elsewhere in the Governor's statement, the RBA's view on the global backdrop was mixed with prospects for global growth now assessed as "continuing at a moderate pace" but Australia's commodity prices continuing to decline (vs "softened" last month). Global financial conditions were noted as very accommodative with capital flowing freely again to emerging markets, and volatility unusually low - the Bank questioning perhaps the implication that markets attached little prospect to a rise in global interest rates.

There were several points of interest in the Bank's assessment of domestic conditions. Growth was now seen more clearly as having firmed around the turn of the year but this was partly the result of "very strong increases in resource exports as new capacity has come on stream, but smaller increases in such exports are likely in coming quarters". ABS trade data out today show net exports made a very sizeable contribution to economic activity in Q1, adding 1.4ppts to GDP growth. Clearly the RBA is not counting on similar outsized contributions in the quarters ahead.

Rather little is made of the recent softening in retail sales and housing indicators with consumer demand still assessed as growing moderately and a strong expansion in housing construction ahead. The recent moderation in dwelling price growth is noted though - a change on last month although a tentative moderation in price growth was referred to in the minutes from the May Board meeting. While not new, the shift in house price momentum may be seen as more convincing and/or significant.

In a similar vein, labour market commentary has also adopted the wording used in the May minutes and Statement on Monetary Policy – where demand for labour being "weak over the past year" has been replaced with the observation that "there has been some improvement in indicators for the labour market in recent months, but it will probably be some time yet before unemployment declines consistently.". The key take-out from labour markets continues to be its implication for the continuation of weak wages growth and subdued domestic cost pressures.

There were a couple of notable absences in the June Governor's statement. The sharp pull back in consumer sentiment following the May Budget rated no mention - with the comments from May's Governor's statement that "some indicators of business conditions and confidence have improved from a year ago" simply dropped.

And on business investment there seemed to be little 'buy-in' from the Bank on the improved investment intentions revealed in the Q1 Capex survey. Although these are always open to interpretation, the Banks assessment that "signs of improvement in investment intentions in some other sectors are emerging, but these plans remain tentative" looks to be a slight upgrade at best on last month's view that "signs of improvement in investment intentions in some other sectors are only tentative".

Conclusion

We never viewed the June RBA Board meeting as 'live', either for a rate move or a significant shift in policy stance. As we have long argued, the evolution of policy from here hinges on the RBA's views around 2015. Recent developments have likely 'cancelled out' in this respect, with a stronger Q1 growth pulse and marginally improved outlook for non-mining capex offset by weaker commodity prices, a patchier consumer and some signs of a slowdown in the housing sector. We continue to expect the RBA to keep interest rates on hold through the remainder of 2014 and much of 2015.

According to an ASIC Smart Money site, Australians have an oustanding credit card debt of around $34bn. The average balance of a credit card is $4,400, so given that interest rates charged on cards are between 15 - 20%pa, this means that Australian credit card owners are paying on average around $800 in interest every year.

With official interest rates currently at 2.5%, and mortgage rates around 5-6%, paying 20% on credit cards doesn't seem a smart move. So here we list a few ways that those with credit card balances can get control over their credit cards.

1. Reduce the credit limit of your card.

2. If you can refinance the credit card using a home loan or cheaper form of finance, then this results in a massive interest saving, assuming of course that you don't simply run up the credit card debt again.

3. Have at least one day per week where you pay cash, and don't use your credit card. This can be habit forming, sort of like an 'alcohol free day'

4. Reduce the number of credit cards you have in your household to one.

5. We generally suggest that people do not have a credit card linked to their mortgage - this only encourages further spending. While old fashioned, we prefer mortgage that are paid on a principal and interest basis, with credit cards kept separately.

6. Control the number of direct debits you have linked to your credit card - this can 'sneak up' on the unwary.

7. Shop around for credit cards with a lower interest rate. These cards may not offer the glitzy reward schemes, but we have seen some 'no frills' cards offer an interest rate of 10%pa - potentially cutting your interst bill in half.

As expected the Board decided to leave the cash rate unchanged at 2.5%.

There were only minor changes in the Governor's compared to the statement following the April Board meeting. We were most interested in the rhetoric around the Australian dollar given that in December it was referred to as "uncomfortably high" at US0.912. Today's level of 0.928 has not evoked stronger language than "the exchange rate remains high by historical standards". Of course this was the language used at the April meeting when the AUD was printing USD0.924 but it was reasonable to expect that with concerns around a lift in inflation having subsided with the March quarter print for core inflation falling from 0.9% in December to 0.52% in March stronger language around the AUD might reasonably have been reinstated.

In the event a preference for no change prevailed over a decision to restore a successful strategy that assisted in the fall in the AUD from USD0.95 to USD0.87 through 2013.

There were only four other changes in the statement from April:

1) recognition that commodity prices have recently softened;

2) describing the outlook for the housing construction cycle as "strong" rather than "solid";

3) recognising that the unemployment rate had fallen in March but maintaining a cautious view towards the labour market by indicating that "it will probably be some time yet before unemployment declines consistently";

4) linking ongoing weak wages growth to a moderation in the prices of non-traded goods and services. This link had been a source of some frustration for the Bank given that wages had clearly weakened but non traded inflation had been stubbornly high. It appears that this was the most significant take-out by the Bank of the surprise 0.52% print in core inflation for the March quarter rather than recognising that the pass through from the weak currency in 2013 had largely run its course in the December quarter.

Conclusion

The Governor repeated the key statement that "the most prudent course is likely to be a period of stability in interest rates". Our view that rates will remain on hold until the second half of 2015 is not widely held by other economic commentators with two thirds expecting rate hikes by early 2015 and some still anticipating rate cuts.

From our perspective encouraging evidence around the consumer, residential construction, exports and jobs preclude the need for lower rates whereas extensive spare capacity, a high AUD, the ongoing downturn in mining and a rising unemployment rate (despite a stronger jobs environment than in 2013) all point to an extended period of interest rate stability.